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Defining the Stance of Monetary Policy Is Harder than It Looks

Jeffrey Hummel has listed four points in a response to our recent discussion, and then one more in a separate post. I agree with much of what he has to say, but there are enough points of disagreement that it’s worth going through these one at a time:

I agree that the financial crisis was a real shock, but would add that I (and I believe Hamilton as well) believe high oil prices also played some role in the early stages of the economic slowdown (2007-08.) On the question of regulation, I have mixed views on the question of whether more or less regulation is desirable. I do feel that deposit insurance and “too big to fail” have created perverse incentives, and that this explains some of the excessive risk taken by banks in recent years, and by S&Ls in the 1980s. If it is politically impossible to come up with a more sensible insurance scheme, then I think we might want to consider one more regulation. I am attracted to the Canadian system, which I believe has a 20 percent minimum requirement for down payments on mortgages. Even though I don’t think the financial crisis made a severe recession inevitable, there is no question that it at the very least interacted with flawed monetary policy in a highly destructive way. So I think some regulation can be defended on the basis of “second best.” Earlier I mentioned that I would favor less government involvement in other areas, particularly all the entities and regulations that encourage home ownership. I believe most if not all of us agree on this point.

I agree with most of point two, with one exception. I do not believe that Hamilton thinks monetary policy was ineffective last year, at least in the usual Keynesian sense of a liquidity trap. Just a couple days ago in his blog (econbrowser.com) Hamilton mentioned that the Fed began paying interest on reserves last fall in order to prevent high inflation. That view is certainly not consistent with the Keynesian view that monetary policy was ineffective at zero rates. Hamilton can offer his own view, but I am pretty sure that he felt policy could still have boosted AD, but that long and variable policy lags prevented it from having any near term impact on the sharp drop in output last fall.

I agree with Michael Woodford that changes in the expected future path of monetary policy are far more important that changes in the current setting of the monetary instrument. On the other hand I disagree with Woodford’s view that the short term interest rate is the proper monetary instrument and indicator. Instead, I think changes in the future supply of money are of key importance. So I view policy in terms of the monetarist “excess cash balance” transmission mechanism.I disagree with the monetarist view in two areas. I focus on changes in the expected future path of policy, and not the current setting of policy. And second, although I believe it is best to think of monetary policy in terms of changes in the money supply, because velocity can be unstable I believe changes in NGDP forecasts are the most useful indicator of the stance of policy.

I define monetary policy in terms of expected changes in NGDP. My view that monetary policy was therefore highly contractionary last fall is considered rather bizarre by almost all economists. Hummel suggests that a contractionary monetary policy is one that decreases the money supply, and if NGDP falls because of lower velocity, that should be considered a velocity shock, not tight money. Let’s examine this issue from a different angle. Suppose last year that the Fed had steadily raised rates from two percent to eight percent during 2008. And suppose everything else was the same. The money supply still increased and NGDP still fell sharply in the second half. I claim that most economists would have viewed policy as being highly contractionary. And I think Hummel would agree that most economists would have had this view, as he himself notes that “most economists” view interest rates as the best indicator of monetary policy. But Hummel also states that he finds my critique of the interest rate view of monetary policy to be “persuasively” argued.

So far I haven’t address Hummel’s view of policy. But I have shown that the vast majority of economists view my definition of the stance of monetary policy as being bizarre, solely for reasons that Hummel himself finds inadequate-the interest rate indicator. So maybe my view isn’t so preposterous. Now let’s consider the money supply. The Fed nearly doubled the monetary base last fall. The base is the monetary aggregate that I find most useful, because it is a tool that the Fed can directly control.

Many economists think changes in the base are the most straightforward way of defining the stance of monetary policy. But not all. Friedman and Schwartz, as well as some other monetarists, believe that the Fed conducted a “tight money” policy during the early 1930s, despite the fact that the monetary base rose sharply. So now we have two groups that are willing to call money “tight” at the same time as the Fed is pumping lots more money into the economy. One group is mainstream Keynesians of all sorts, those who focus on interest rates. That’s most of the profession. And another group is traditional monetarists, those who think money was tight in the early 1930s.

I don’t know what version of “M” that Hummel prefers. But I do know that economists are all over the map as to what the terms “easy money” and “tight money” really mean. In that case I am inclined to throw up my hands and ask this pragmatic question:

In a fiat money world where the central bank has almost limitless ability to pump money into the economy, and impact the expected growth of nominal aggregates, what is the most useful definition of the stance of monetary policy?

Since I believe that the Fed should target the expected growth rate of NGDP on a daily basis, I decided the most useful way to think of “easy money” was as a policy expected to lead to above-target nominal growth, and vice versa. Is this so unusual? I notice that those who favor targeting interest rates (Keynesians) define the stance of monetary policy in terms of interest rates. And I notice that many who favor targeting the money supply (monetarists) tend to define the stance of monetary policy in terms of the money supply. I prefer to target NGDP expectations. So that’s my policy indicator.

In a later post Hummel thoroughly demolished my interest penalty on reserves idea. I just have a few comments. I probably directed the question at the wrong group of economists. It was a thought experiment intended to show that the Fed had not run out of ammunition, as most economists seem to believe. However I don’t believe that this group of economists thinks the Fed ran out of ammunition. So we are outliers. I agree with Hummel that negative interest is not optimal, and that some of my other policies are more than adequate. But I do think he slightly overstates the potential problems.

The impact on bank profits can be eliminated by a two tier scheme; negative interest on excess reserves and positive interest on required reserves. These rates can be calibrated so that banks remain competitive with MMMFs.

Vault cash is easy to deal with, just cap the amount of interest-free vault cash at a level above what any reasonable bank would want to hold. If the Fed had done so, any future open market operations would, at the margin, go toward expanding the broader aggregates, rather than being hoarded. Then most banks wouldn’t have to bother counting vault cash each week. (Do they do this now? If so, the definition of reserves could include vault cash.)

The yield on T-bills might go slightly negative, but only up to the point where it becomes profitable to hoard cash in safety deposit boxes. Again, this isn’t my first choice (NGDP futures targeting is) but I think it could be made workable.

I’m not worried about a tax on cash held by the public, it is currently technically impossible to implement. On the other hand at some time during the 21st century I expect all cash to be removed from circulation, and replaced with some sort of electronic money (debit cards or cash cards.) I don’t like the idea, but I think it is inevitable. At that point interest rate targets will be once again feasible in a liquidity trap, and Keynesian economics may be reborn for a third time.

Despite these reservations, I agree with much of what Jeffrey Hummel wrote, and think he did a good job clarifying the issues for Cato readers.

Also from this issue

Lead Essay

In this month’s sure-to-be controversial lead essay, Bentley University economist Scott Sumner argues that almost everything economists and economic policymakers thought they knew about the role of monetary policy in the recent recession and financial collapse is wrong. Sumner contends that the resources of monetary policy were not exhausted, as many economists believed, but were barely used. Flying in the face of conventional wisdom, Sumner maintains that monetary policy in the run-up to the finacial crisis was not highly expansionary, but was in fact disastrously contractionary. Sumner offers a short history of monetary economics to put into historical perspective the role of allegedly failed monetary policy in the financial crisis and recession. He proposes a strategy for central bankers — targeting forecasts of nominal GDP — that might help avert future crises. In conclusion, Sumner warns of the political dangers of misdiagnosing the crisis: unless the record is set straight, free markets will once again take the fall for a failure of monetary policy.

Response Essays

University of California, San Diego economist James D. Hamilton disputes Scott Sumner’s claim that the sub-prime crisis was a fluke with few lessons for macroeconomics. According to Hamilton, the booming U.S. housing market represented a “huge misdirection of capital,” and the overexposure of key financial institution to the housing market’s downward correction crippled lending and sent the economy into a nosedive. Hamilton agrees that the Fed might have limited the damage had it kept the growth rate for nominal GDP higher, but he disagrees with Sumner about the tools available to the Fed to achieve this. Hamilton notes that tools available to the Fed depend on which of the possible specifications of the money supply and its velocity actually determine nominal GDP. Hamilton says unconventional paths to monetary stimulus were open the Fed in late 2008 and that “the preferred policy … would have been to acknowledge more aggressively the losses financial institutions had absorbed on existing loans, impose those losses on stockholders, creditors, and taxpayers, and retain as the Fed’s first priority the stimulus of nominal GDP rather than trying to lend to everybody.” Hamilton concludes with some worries about Sumner’s favored tool for targeting nominal GDP growth.

University of Georgia economist George Selgin agrees with Scott Sumner that “tight money was the proximate cause of the post-September 2008 recession” and that “a policy of nominal income growth targeting might have prevented the recession.” Selgin encourages Sumner to acknowledge the role easy money played in the subprime crisis, and argues that Sumner’s five-percent nominal income growth target is “unnecessarily and perhaps dangerously high.” Selgin favors a two or three percent target, which he contends would be less likely to perpetuate boom-bust cycles.

San Joses State’s Jeffrey Rogers Hummel begins with a brief history of economic thought about the causes of the business cycle, which leads to a call for “a measure of epistemic humility.” Hummel signs on to much of Sumner’s story about the Fed behavior in 2008, and accepts his criticism of the widespread use of interest rates as the main indicator of monetary policy. But Hummel departs sharply from Sumner’s prescription for better monetary policy — a rule to target the forecast of nominal GDP growth. “The … critical defect of Sumner’s Rule,” Hummel argues, “is its blithe assumption that money, unlike any other good or service, requires not merely government provision but detailed, sophisticated, and flexible government management.” Hummel raises doubts that even the best such rule would be well-applied, and calls for the “abolition of the Fed, elimination of government fiat money, and complete deregulation of banks.”

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